Crypto-funds: a sea of opportunities but an ocean of risk

14/05/2018

Absent from our vocabulary until 2008, Bitcoin has now registered in excess of 340 million searches in Google, a figure that compares to the total searches for the word “Luxembourg”. So what is it? Bitcoin was the very first cryptocurrency, created in 2008. Just ten years on and more than 1500 crypto currencies have been launched with a total capitalization of 500 billion USD (1 Feb. 18).

2017 witnessed a strong rise in crypto currencies. The spectrum of new investors ranges broadly, mainly divided into three categories - a tech population known as « Crypto Traders », sophisticated investors seeking exposure (crypto hedge, crypto funds) and a retail population in the quest of the next ‘Gold rush’.

The Asset Management industry, keen to be at the forefront of innovation, is constantly on the lookout for new investment opportunities to attract new clients. And crypto-funds have come on their radar as just such an opportunity.

Crypto currencies could be the next asset class – but could we be opening Pandora’s box? And what are the main risks?

Since 2013, more than 150 crypto-funds have been launched, especially in the US, where hedge funds are the preferred vehicle. According to a research performed by the ALFI (Association Luxembourgeoise des Fonds d’Investissement), the market size could be between 10 and 15 billion USD. The top 3 worldwide funds alone have a value close to one billion dollars.

Some of these funds are actively managed, others are passive, while others are a mix of crypto-assets and blockchain investment.

As the old adage says, there is no profit without risk.

Several regulators (like AMF in France or SEC in US) or more broadly securities associations (ESMA) have warned investors about the risks associated with crypto currencies. These fall into 5 major categories, having a strong impact in terms of investor protection:

Security risk: the storage of digital assets is done based on cryptographic methods (private / public keys). Private keys are kept private like a computer password. These keys have become a target for hackers via spyware, wifi…. Digital assets should be recorded with a cold wallet to reduce the potential of cybercrime and companies have emerged (eg Ledger) that offer such solutions. The risk should not be underestimated - recently, the Japanese platform Coincheck was hacked and the equivalent of USD 536 M in NEM assets were stolen.

The volatility of the crypto assets, often perceived as a trading opportunity, presents a strong counterparty risk. The basic premise is simple - you can lose all your money. Any cryptocurrency can lose its value overnight and it has been already the case with the Initial Coin Offering Tezos.

Furthermore, a high number of exchanges are not regulated and have no quality commitment, regulatory capital, nor risk management policies. The exchange you keep your coins on can just disappear and you will never see your coins again. There is no investor protection in cryptocurrency trading because it is not a regulated market. This was the experience in December 2017 when the market was going down.

The classification of crypto currencies (assets, other assets …) is a crucial element as it determines how the depository bank should behave in case of default. As this classification is still not defined in several countries, it is difficult for asset servicers to enter the market, taking into account the additional risk. Recently, the Indian government proposed to issue a law deeming that crypto currencies should not be recognised as a currency. Clearly there is a legal risk that jurisdictions could restrict or even outlaw cryptocurrency trading.

Finally, the reputation risk is significant, especially when considering your choice of digital asset & counterparties. Understanding the protocol and strong due diligence can mitigate this risk, but it is nonetheless essential to choose a crypto currency backed by solid fundamentals, cognizant of the risk of scams and false promises.

In conclusion, crypto-funds offer the opportunity of significant returns for investors. However, regulatory uncertainty and high risk are proving to be a significant hindrance to the development of such vehicles in a regulated framework.

Crypto-Funds ; a sea of opportunities but at the same time, an ocean of risk.

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